Wednesday, September 5, 2012

Supply Side v. Keynes, Pt. II: Our Real Problem Is Lack Of Demand

Consider the following from Keynes' General Theory:

But this, I have to point out, should not have led us to overlook the fact that the demand arising out of the consumption and investment of one individual is the source of the incomes of other individuals, so that incomes in general are not independent, quite the contrary, of the disposition of individuals to spend and invest; and since in turn the readiness of individuals to spend and invest depends on their incomes, a relationship is set up between aggregate savings and aggregate investment which can be very easily shown, beyond any possibility of reasonable dispute, to be one of exact and necessary equality. Rightly regarded this is a banale conclusion. But it sets in motion a train of thought from which more substantial matters follow. It is shown that, generally speaking, the actual level of output and employment depends, not on the capacity to produce or on the pre-existing level of incomes, but on the current decisions to produce which depend in turn on current decisions to invest and on present expectations of current and prospective consumption. Moreover, as soon as we know the propensity to consume and to save (as I call it), that is to say the result for the community as a whole of the individual psychological inclinations as to how to dispose of given incomes, we can calculate what level of incomes, and therefore what level of output and employment, is in profit-equilibrium with a given level of new investment; out of which develops the doctrine of the Multiplier. Or again, it becomes evident that an increased propensity to save will ceteris paribus contract incomes and output; whilst an increased inducement to invest will expand them. We are thus able to analyse the factors which determine the income and output of the system as a whole;—we have, in the most exact sense, a theory of employment. Conclusions emerge from this reasoning which are particularly relevant to the problems of public finance and public policy generally and of the trade cycle.

The emboldened lines are a key statement which illustrate why Say's law -- and supply side economics -- are the incorrect script for today's situation.

First, as I showed yesterday, the US has already implemented supply-side policies. We're already taxed at a very low rate relative to GDP. As a result, corporate profits and cash are already near all-time absolute highs. And investment has already returned to pre-recession levels. Under basic supply side doctrine, the creation and implementation of this overall environment should lead to more demand -- that is, supply should be creating some type of demand.

But, that in fact is not happening. Instead, demand has been lackluster. Consider this chart:

Above is a chart of real personal consumption expenditures on a "percentage change from last year basis." I've drawn a long black line from the current level all the way back to the beginning of the data series. In addition, I've boxed the usual levels associated with a recovery for the same time period. Notice that the usual year over year percentage change in PCEs is actually far higher than the current level. While we did see a nice bump at the beginning of the current recovery, that can also be explained as a simply reaction from a historically and abnormally pronounced collapse following the 2008 financial crisis.

The bottom line of the above data is that demand is very low by historical measures. And the reason is we're in the middle of a debt-deflation recovery, where people are just as likely to pay-down debt as purchase a new good or service. That means there is traditionally lower level of demand. As such, there isn't as strong a reason to invest in new production or capacity.